The FCFE valuation method is one of several techniques used by analysts to determine intrinsic values for equity securities. Since FCFE is a direct method for equity valuation, it avoids some of the pitfalls related to Free Cash Flows to the Firm (FCFF) method which requires market values of equity to determine the discount rate known as the Weighted Average Cost of Capital (WACC). FCFE only uses the Cost of Equity as the discount rate for the specific firm being modeled. The Cost of Equity, r_e, for a firm is determined through the Capital Asset Pricing Model (CAPM) defined as:

where r_f is the risk-free rate, r_m is the market return rate, (r_m - r_f) is the market risk premium and &beta is a factor that relates the recent historical returns on the firm's stock relative to a market portfolio. In the US, the risk-free rate is determined from the 10-year Treasury Bond rate based on its low default risk. The market risk premium is determined through analysis of historical risk premiums observed in the market and ranges in value from 4.84% [Damadoran] to 7.6% [Ibbotson Associates, 1998] based on the different methods used to determine this risk premium. &beta is defined as:

In general, firms with high growth prospects usually have a &beta > 1 and firms in stable industries with steady-state growth tend to have a &beta < 1. A firm with returns that track the market portfolio perfectly will have a &beta = 1.

As an example, assume that the risk-free rate is 4.5%, market risk premium is 5.2% [Fama] and &beta = 1.1. The cost of equity is:

InValueAble.net uses a default cost of equity of 10% which is represented by "10.0 %" in the cost of equity input field. This default value is backed-up by historical research on US nominal annualized equity returns of about 10.1% [Bodie]. While performing the analysis for a specific firm, the user should consider the risks of the firm's cash flows and use the CAPM as a basis for making any adjustments to the firm's cost of equity.

The Free Cash Flows to Equity (FCFE) valuation method can be defined in terms of total Equity Value (EV) as:

A mathematical relationship of the FCFE method can be expressed as:

where FCFE _t is defined in its simplest form as:

FCFE = Net Income (NI) - Increase in Book Value of Common Equity (CE)

or as

FCFE _t = NI _t - (CE _t - CE _t-1)

The FCFE equation requires input from the Income Statement (Net Income) and Balance Sheet (Net Common Equity) for the forecast periods. InValueAble.net automatically sets up pro forma financial statements based on historical firm data (cost structure, asset & liability structure) with revenue tapering linearly down to a terminal value (or continuing value) of 5%. These automatically generated pro forma financial statements drive the FCFE equations above to establish the default intrinsic value of the modeled firm, but this value might not reflect all the relevant information required to perform a reasonable forecast of the firm's performance based on the firm's prospects. The user must seek the most up to date and relevant information, analyze that information and convert it into meaningful forecast ratios with the proper extraordinary growth period and steady-state ratios to develop a reasonable forecast of the equity value and resulting intrinsic value per share of a firm. More on this topic will be discussed in Getting Started section.